Better Buy: Altria Group Inc. vs. Reynolds American

By Markets

The tobacco industry is highly profitable, and both Altria Group (NYSE: MO) and Reynolds American (NYSE: RAI) have done a good job of rewarding shareholders over time as the major players in the U.S. tobacco market. Yet for investors looking to choose between the two, which cigarette giant is the smarter pick right now? Let's compare Altria Group and Reynolds American on a number of metrics to see which one looks more attractive under the current conditions.

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Image source: Reynolds American.

Valuation and stock performance

In terms of stock returns, both Reynolds American and Altria have produced double-digit percentage returns for their investors. But Altria has managed to outpace its smaller counterpart, producing a nearly 20% total return since October 2015. Reynolds has produced a total return of almost 11% over the same time period.

Given its greater advance, Altria stock might seem to be more expensive than Reynolds, and using the most basic earnings-based valuation measures, that impression looks correct at first glance. Altria currently trades at almost 22 times trailing earnings, compared to just 13 times earnings for Reynolds. However, Reynolds American's results include some one-time gains that aren't likely to recur. Therefore, when you look at future earnings expectations, the two tobacco stocks' valuations converge. Both Altria and Reynolds trade at about 18 times forward earnings. Unless you think those forward estimates of earnings are fundamentally flawed, both tobacco companies appear to have similar valuations.

Dividends and return of capital

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Both Altria and Reynolds have distinguished themselves in the way they treat their investors. In terms of current income, the two are once again in a dead heat, giving their shareholders dividend yields of about 3.9%.

Dividend growth is also a key aspect of both companies' dividend philosophies. Reynolds recently gave investors a boost of $0.04 per share in the quarterly dividend, amounting to an increase of nearly 10% and marking the second time in 2016 that it has paid more cash to investors. Altria also made a dividend increase, pushing its payout higher by 8%. Altria has a longer history of dividend growth, but Reynolds has done a good job of catching up, tripling its payout in the past 10 years.

Both companies have supplemented ample dividends with modest buyback activity. Share repurchases have slowed somewhat in recent years, but overall, both companies have done a solid job of treating their shareholders right by sharing their success through dividends and buybacks.

However, Reynolds recently made big changes that could reward shareholders more. The company announced that it would move its target dividend up to 80% of earnings, up from 75% and leading to the 10% dividend increase discussed above. Also, Reynolds announced a $2 billion stock repurchase program. That gives Reynolds the edge in shareholder-friendly moves -- for now.

Growth prospects and risks

Tobacco has faced long-term challenges, and Altria and Reynolds American have both worked to navigate the changing environment for cigarettes and other tobacco products. In addition, both companies have undergone substantial changes that will have implications for their entire businesses going forward.

For Altria, making the most from weak revenue performance has been essential. In Altria's most recent quarterly report, the company reported that sales dropped 1.4%, but it managed to produce a 14% rise in net income. Strength in pricing helped Altria squeeze out gains from its cigarette segment, and strong performance from smokeless tobacco and the wine segment added to the company's overall success. Looking forward, the imminent closing of the merger between Anheuser-Busch InBev (NYSE: BUD) and SABMiller will convert Altria's stake in SABMiller into a roughly 10% holding in Anheuser-Busch shares, giving it exposure to the global beer industry and providing some valuable diversification. It will also free up about $3 billion in cash, which Altria will have to decide how to handle in the months to come.

For Reynolds American, the integration of the Lorillard merger has continued to generate encouraging results. Revenue jumped by a third in the second quarter of 2016, helping to send adjusted net income higher by 43%. On a per-share basis, the growth numbers were slightly more muted, but gains of 14% in adjusted earnings per share were still impressive. With manufacturing of Lorillard's Newport brand having been successfully integrated in June, Reynolds sees more ability to share its success with investors and expects further strength in the future. Like Altria, Reynolds is also promoting alternatives to traditional cigarettes, and CEO Susan Cameron pointed to the Vuse line of digital vapor e-cigarettes as leading the market.

Right now, Reynolds American has slightly more momentum than Altria in terms of growth and dividend treatment. In the long run, though, both Reynolds and Altria look like they have the potential to keep producing the same returns that have made them such good investments for decades.

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Dan Caplinger has no position in any stocks mentioned. The Motley Fool recommends Anheuser-Busch InBev NV. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.